Saturday, May 17, 2014

Behind the Hype – Understanding the Economic Impact of Political Change

I have always believed that the Indian economy functions despite its political environment. Somehow, the entire economic system has learnt to function despite the endemic political chaos, political inertia and high transaction costs related to the above. And when good politics emerge for short spans, we rejoice because the costs have come down for now. I doubt any business in India assumes stability or continuity in a real sense. It’s like a pipe dream. Basically, the economic system in its entirety functions largely in auto-pilot.
But there are no shortcuts. The economic system is very complex and even a hundred small things take time to have either an upward or downward cascading impact of any kind. One of the most fundamental and most often used phrases in economics is “ceteris paribus’. But in the real world, this is the most ignored aspect because frankly, nothing really stays constant so viewing one aspect of economic growth or development intrinsically impacts the other.

For example, let’s take the example of something that’s affecting us all – inflation. This, in India, is largely driven by the rise in food inflation. This intuitively makes sense. If basic essentials are costly, ingredients of most other commodities get costly as well. But, what will keep this in check? A change in policy decisions, subsidies, monetary controls or all of the above? Or, could it be that the inflationary impact on and of the food sector is driven by systemic issues - the cushion for the existence of middle men, corruption in middle men, the lack of interaction between core producers and end users or even wholesalers? This complicates further when you think of the role of transaction costs.

Think of this scenario: A farmer is empowered with information and knows his produce can be sold for more. However, he has no roads or infrastructure to physically connect him with the buyers. So, despite other things in place, he is still at the mercy of the middle man with the power and resources to connect the village with the end users. The farmer does not get the right level of income and hence he stays at a level where he needs government support and the subsidy bills rise – you can understand how this is a never ending spiral. All this of course is ceteris paribus but then that’s the only way to understand the fundamental issue. My point is this:  there is no simple long term solution. A number of small and not so small things need to fall in place – either sequentially or in a random order for the complete dynamic to change.

The same fundamental principle applies to almost all aspects of economic development. It is all complicated and takes time to create as well as undo. If we saw a decline in the past few years, it was probably not only a political decline – it was probably just the undoing of some quickly taped on solutions. Continuity was never guaranteed and policy decisions reversed easily are a recipe for disaster.

Fundamental economic history will tell you that good markets have existed way before money markets. They survived on a simple principal of barter. Hence, the money market and currencies emerged as tools to aid the good market growth. Logic then tells me, that fundamental economic chaos that we are seeing now can be stemmed at both these levels. The goods and the money market – inflation for instance is not just a function of money markets but of the impact of high transaction costs of doing business. Trading, agriculture, services, and industry – everything has relatively higher costs exacerbated by poor implementation of sound policies, lack of infrastructure and lopsided political will.

Back in 2001, India emerged on economic growth radars after the BRIC report which placed it as one of the key growth economies in future. This was quickly followed by actual growth in India and the great Indian growth story was created. A dream was created and spread like wildfire – fueling actual growth and returns for many. It also raised expectations significantly. Hence, when the realities of global inclusion and interdependence hit the snowball began to melt. And then the political scams and lock jam shattered the dream. But the expectations remained – that India could be that great growth story. We had the potential. We all believed it.

So what happened in the last couple of years to make it all seem so bad? The fundamental system stopped working – and it seemed like everything was going to be sluggish for a while. But with the hope of stability and political change, most people are waiting for this phase to end and for that magic pill to quickly put everything on the fast track again.

We are now at, what most people believe to be, an inflection point of positive change – the stock market definitely thinks so already. I am not saying that things won’t be impacted, all I am saying is that will take time. A lot of time! Basically, the cycle takes time. First, decisions at policy levels need to be agreed to then the system needs to implement them. Also, not all industries are currently directly impacted by policies – so we are largely saying infrastructure and core sectors are likely to get impetus first. But the impact of these sectors is a slow trickle down. In short, the goods market is likely to see a pick up – but eventually and not immediately.

As far as the money market goes, those changes are in place already – again despite the political situation- and these will continue to have an impact at the current pace.

To me, the economic hype around political change this year is not what the hype is all about. The timing for returns is what has been hyped up.  There is no magic wand, no one person and no one day that can change it all. It is system that will work part by part piece by piece once it is re-started. Yes, the hope has emerged that the fundamental blockages will be treated which will get the water, power and other basic essential moving. But these are cogs in the wheels of change. The real value will come beyond the hype of the cogs being in place. 

Thursday, August 22, 2013

Big pictures, Small details, – The Nuts And Bolts Of Valuing A New Set Up

When you study accounts, you are taught to pay attention to every tiny detail. Every bit of finished goods needs to be derived from raw materials, work in progress and the reach its current state. Every invoice and value has to tally up. All the small things somehow have a multiplier effect on the balance sheet and errors show up if things are missed. Unlearning this habit when developing a valuation assessment for a set-up, is not an easy process – but a necessary one.

I am not saying in any way that misrepresentation is required, simply that generic assumptions, and missing some tiny details when creating a financial model for valuation/investment purposes is perhaps more prudent and quick. Because really, for valuation, the multiplier effects of the smaller things are really minimal. The question to ask when dwelling on a small issue is – is this going to materially impact the value of the company. This is especially true for newer set ups where all the smaller elements are not necessarily tied up – and waiting just adds to frustration and inertia.

From an entrepreneur’s angle, understanding the fundamentals of what really will impact your business value goes a very long way by helping you to make sound strategic decisions prior to approaching investors. Unlocking intrinsic business value is necessary step for investment.

Simple questions like, “should the land on which the business is run be owned by the entrepreneur, the business or a third party” are often asked. This ideally requires another level of questioning i.e. is the land going to be used for financing, does the owner want a separation of his land ownership from business ownership, etc.  If used for financing, then the land has to necessarily be on the books of the business. If not, then the land can be leased by the business from the owner of the land (even if it is the same as the promoter of the business). The leasing route however, means that while your land is safe and insulated from the businesses liabilities, the value of the business will be lower.

Another conundrum for valuation can be depreciation. It’s basically a book entry with no cash impact – other than the tax perspective. So essentially, when valuing a company which is either enjoying a tax holiday or does not need to pay taxes for whatever reason, the depreciation really is immaterial – it’s a book entry which needs to be factored in but not really bothered about.

“Others” can be a very useful head for new set-ups where small details can be clubbed for a quick valuation assessment of undecided items. These are usually not large enough to impact the business value in any way and involve a lot of time and effort to sort out. They are essential to the business no doubt and need to be sorted out before you start. But, can be done while valuation negotiations are underway.

Next, the king – cash. The alluring net profit line and margins which drives a lot of entrepreneurs really means very little if the cash in the business (sitting on the balance sheet) is at an unhealthy level. The two go hand in hand but the cash figure is what you really need to look out for – because that will give you your reserves to weather any storms.

Finally, keep in mind that the on paper valuation and the value you will agree to rarely coincide in any way. These valuation exercise are a starting point for discussions and the actually value most new businesses have is more intangible in nature. A Discounted Cash Flow Method (DCF) does take into account a lot of things but it is a very optimistic view on the business. On the other hand an asset valuation will lead to a close value-free assessment. Other methods such as comparable-valuation do not really apply to new businesses.

The big picture is this: A solid product backed by management confidence, trust, honesty, past record for performance in other businesses etc is what actually clinches most deals – not the excel sheet numbers. Negotiation ability of course is the icing on the cake.

Thursday, July 25, 2013

An Idea, a Plan, a Spirit: Your Start-Up Ticks Like You Do

Legally, your organization and you are recognized as separate individuals. But beyond legality, the lines are more often than not very blurred. This is especially true for start-ups and the entrepreneurs with big dreams and ideas.

How often have you, as an entrepreneur, found yourself funding that one marketing expense out of your own pocket? That land your factory needs can be your own asset - then the money is all with you right? Wrong – in reality, if a business has to be run like a business it has to be separate from you – so if your business owes you something, it owes you – you cannot write it off saying it’s all mine. Again - that’s the legal stand point.

Reality: You are one with your business, so embrace the concept in spirit. The idea for the venture usually is a big dream. And a dream has a fundamental premise. You, as the dreamer, have a certain ideology backing up that dream. The details of the implementation plan will include how you want to fundamentally do business. What kind of an organization do you want to build? What sort of customers do you want to attract? What values will your venture stand for? What is the core reason for your setting up the venture?

“I want to make money” is rarely the only aspect that drives anyone to set up a complete business. If that is the purpose, then your business will and has to be focused on that end only.  So business volumes at the cost of quality could be one way to go. The core thing to keep in mind here is that if you have “money” as your core purpose, you should be alienated from your business and essentially work on building it and packaging it for a good exit X years down the line. Because a sell-out is the best way to actually get the best returns – assuming you have set up a successful business.

That is just one scenario. More often, it’s a case of a dream too big to sell so easily. Ideals that want to leave a legacy and pride in ownership is what drives most entrepreneurs. But when the business reaches a growth stage, the lines get blurred - because the business needs seem to take over. This is what I like to call a sort of inflection point. Most often, letting go of core ideals and beliefs and pandering to the “generally executed” norms, often leads to a confused organization and an even more confused strategy which may not be in sync from start to finish. Also, remember, when you decided that this was a winning business, it was based on a package of what makes you (and therefore your organization) tick. Take that package away, and the foundation is gone.

Your organization will be a reflection of you. A plan needs to be flexible but not at every level. Unless there is an earthquake, more often than not, a sturdy foundation is what holds a building together. Same goes for your venture. Keep certain non-negotiable ideals and strategies which are close to your core – it will keep you in sync with your set-up. And if you are in sync with your set-up, you know you can steer the course. 

Monday, July 15, 2013

Investor, Partner or Direction: Choosing the source of funding and the strings that come attached

Equity is often less daunting than debt – we all know that. However, equity often comes with hidden costs and strings that can be tougher to traverse than debt – especially if you do not understand what kind of investor your company actually needs.

Broadly speaking, equity funding is usually divided into two broad areas i.e. strategic funding and pure equity funding.

The former is fairly self explanatory – it entails a strategic investment which provides either forward or backward linkages to both entities.

A strategic investor by definition will look beyond the numbers – he will look at synergies. Often, the strategic investor will see value in processes, customers, markets, employees or technology. A lot of these will be intangible in nature and will be changed as a result of the strategic tie-up. This sort of investor will inherently be involved in the daily functioning and will want a say in how your business is run- a big say. 

More often than not, people issues and organizational synergies become the biggest stumbling blocks in strategic relationships’. This is because after the I’s have been dotted and T’s crossed, the implementation is a people driven , operational process and core values, organizational culture and dynamics has the biggest role to play.

If the synergies are strong enough and the implementation noise manageable, this is one of the fasted ways for an organization to grow – since it is actually two strategies, a new vision and double resources (almost) that can expand to new markets, customers , etc at a pace which is unmanageable through regular growth patterns.

The second type of funding i.e. pure equity funding comes in a variety of forms. The broad investor type that you are looking for will depend on the stage of your business cycle.

The earliest forms of funding are angel and seed funding wherein small amounts of money are given to start-ups. These almost always come coupled with expertise and a hand-holding program to ensure the start-up takes off as expected. This is the best form of funding if you are looking for significant value add and are comfortable with a lot of attached strings – tangible and intangible. The biggest upsides are that once angel of seed funded, a set up minimizes its start up risk. Also, the next few rounds of funding for growth are a lot easier if you have an angel or seed fund backing you up. Often these funds give you the option of a combination of debt and equity investments. Debt is almost always available if you approach an incubator facility for your start-up.

The other option is venture capital funding which are more pure-play financial investors and look primarily for quick financial returns. The usually part with relatively larger amounts of money but their requirements are far more aggressive. They need fast returns and fast exits from your business so the pressure is tremendously high. The upsides are similar to angel funding with the addition of more autonomy in daily functioning - as long as you remember the aggressive strings attached and high standards that they will usually put forward.

Finally, there is traditional private equity funding wherein larger amounts are invested and the time frames for exit are also longer. Depending on the nature of the industry that the fund is interested in, they are often willing to wait for over seven years for an exit. As with all forms of funding this will entail giving a board seat (the number depends on the equity share that they hold). Some PE funds work like strategic investors i.e. they like to be closely involved which majority play the role of a financial adviser. They often invest across industries and usually enable synergies between their investments. The strings attached differ with the investment size but by and large they bring in professionalism, business relationships and a lot of direction the set up.  

Of course, you need to be sure you are ready for an equity investment and prepare your organization. Once that’s done, an equity relationship is a play of equity share, the value they assign, the value they get and whether you can deliver on your plans – because once you sign, the strings are expensive to break.

Sunday, July 7, 2013

Bringing in the Outsider: Are You Ready For Private Equity?

For a long time now, Private Equity (PE) has been seen as the easiest solution to financing needs. At each stage of business growth, funding needs can be met by simply giving an agreeable stake in your business to someone who brings money (and a lot more) to the table. However, like most things, there is nothing simple about the process.

The key question that puts the process in perspective is: Are you really ready for an outsider to be a part of what has been just yours – to have them in your meetings, involve them in strategy, and get clearances from them and to use their inputs for fruitful organizational change.

The above may sound overwhelming, but remember – a PE investor brings in lot more than just money.

PE capital though expensive, is ‘smart money’ and PE firms, despite being typically minority shareholders, meaningfully contribute towards the growth and success of their investee companies. Success of these investments is dependent on the success of the venture/business.

The investors ensure that the entrepreneurs are helped with all resources and learning which can be mustered by the fund.  The investors also enable entrepreneurs to achieve success that may have otherwise been beyond reach by providing value enhancement over and above money. For example, improvements in corporate governance, strategic direction, board advisers  access to network of partners and customers, additional capital - equity and debt, etc.

The starting point of the process is to understand your own business, objectives and motives for the investment. There are some basic perspectives to be kept in mind:
  • Understand your own stage of business – expansion is the ideal phase to consider an investor
  • Align your business structure in-line with your core objectives – and how you want to grow your business
  • If a diversified approach is preferred from an operational as well as financial perspective, investments in the existing company may be advisable
  • If a particular SBU is stronger in its own capacity in terms of financial contribution as well as growth, creating an SPV could be a suitable route
  • Understand what PE investors look for and identify the investment point that is more acceptable to their overall criteria and objectives

Once your business objectives and funding objectives are aligned, prepare your organization internally for the change. This usually means some very basic yet essential steps:
  • Take stock of operational procedures that need to be aligned and streamlined
  • Prepare your employees for an organizational restructuring which could come as a result of an investment decision
  • Ensure that all financial reporting systems are in place and that your firm is due-diligence friendly
    • Consider appointing a reputable audit firm
    • Clean-up related party transactions
    • Ensure adequate documentation supporting the books of accounts
    • Consider investing in good MIS or ERP systems to produce accurate data during discussions and post funding
    • Clean-up tax matters if applicable
  • Restructure the company, if required, to facilitate investment in a subsidiary or SPV
  • Have a robust business plan and strategy in place and ensure granularity in projections as well as linkage to historical performance
  • Get a formal valuation done which can be  defended based on your business plan

Ultimately, you are bringing in an outsider which usually means you are migrating from a family run establishment to greater professionalism. It also means that through the process, interests, expectations and control needs of various family members and/or co-owners has to be managed very delicately.

Most importantly, remember to keep your own objectives and plans as the primary factor irrespective of the PE acceptability. Your business was your idea, you need to be open to new opinions and change for growth but, not if you completely alter the core of your business. If you are willing to do that, an outright sale may be a better way forward.